Under the Japanese Companies Act (the Act), outside directors and statutory auditors (kansayaku) cannot be, and cannot ever have been, executive directors, executive officers, or employees of the company concerned or of that company's subsidiaries. However, the Act does not exclude executive officers or employees of parent companies and business counterparties (for example main banks) from appointment as outside directors and statutory auditors, even though their appointment could concern minority shareholders over possible conflicts of interest.
Concerns of both foreign and domestic investors about the traditional corporate governance system in Japan (one that relies on statutory auditors, with 97.7% of the companies listed on the Tokyo Stock Exchange (TSE) as of August 2008 preferring a statutory auditor corporate governance system over one with committees (iinkai)), exacerbated by the global financial crisis and recent increases in management buy-outs, going-private transactions and the adoption by Japanese companies of anti-takeover measures, have led to intense pressure for change. That culminated in a move by the TSE to modify corporate governance requirements for all companies listed on it, particularly mandating greater levels of independence for outside directors and statutory auditors.
However, not everyone agrees that greater independence is necessary, or that it would be easy to implement. Some even argue that a rigid, cookie-cutter approach could harm some Japanese companies.
Below we discuss the background and positions of key interest groups on this topic, and analyse whether the changes proposed by the TSE will satisfy investor demands, or whether additional changes may be needed. The discussion focuses on public companies with statutory auditors.
Background of the TSE's proposal
For years, many investors, especially foreign investors accustomed to a different corporate governance regime, have argued that Japanese companies ought to adopt a transparent process of independent, external supervision of management through outside directors that are truly independent, in order to protect the interests of shareholders. Such investors suggest that global corporate governance standards are converging and that companies on other international stock exchanges have superior systems for overseeing the propriety and legality of the actions of management, mainly because those directors maintain a higher level of independence from management. The corporate governance of companies with statutory auditors involves two-layer monitoring: the supervision by the board of directors with respect to the propriety and legality of actions and the supervision by statutory auditors with respect to legality of actions. The supervision by the board of directors is backed up by its authority to select the director candidates to be approved by shareholders.
However, from a historical perspective, the boards of Japanese companies have mostly been persons promoted to director from within the company, so it may be difficult to expect such a board to effectively monitor the directors' actions. Furthermore, despite repeated amendments to Japanese law to strengthen the monitoring functions of statutory auditors, such monitoring has not been adequate in the view of investors. That can reduce corporate governance transparency, which in turn, could reduce the value that investors are willing to pay to own shares in Japanese companies.
On September 29 2009, the TSE published the Listing System Improvement Action Plan 2009 and on October 29 2009 followed it with Matters for Prompt Implementation based on the Listing System Improvement Action Plan. These new measures by the TSE (the TSE Proposal) will require every listed company to elect at least one "independent" outside director or statutory auditor whose interests are not in conflict with public shareholders. Each listed company will also need to disclose the names of such independent directors and statutory auditors, and describe in its corporate governance reports the reasons why they can be considered to be independent.
Moreover, with respect to any person who: (i) could be influenced by the management (such as an officer or employee of any of its subsidiaries, or any of its business counterparties or partners, or close relatives) or (ii) could have considerable control over management (such as an employee or officer of a parent company, or its business counterparties or other partners (such as main banks) or close relatives) special consideration is needed. Although the TSE Proposal does not exclude such persons from becoming independent directors or statutory auditors, before they can be officially recognised as independent, TSE-listed companies will be asked to consult the TSE so that it can review the independence. Finally, the TSE plans to clarify the criteria by which it will make this determination.
The TSE welcomed public comments through November 28 2009 and, at the time of the writing of this article, implementation is expected by the end of December 2009.
Nevertheless, some groups have expressed concerns over the imposition of the TSE Proposal on all TSE-listed companies, while still others suggest that the TSE Proposal does not go far enough to address investor concerns. The next section highlights these divergent views.
Asian Corporate Governance Association and American Chamber of Commerce
In one corner of the debate is the Asian Corporate Governance Association (ACGA). For investor groups such as the ACGA, having only an independent statutory auditor may not suffice for transparency and objective management oversight. The focus of the ACGA is on independent directors, and together with other investor groups, it would like to see Japanese companies appoint more than one. In May 2008, the ACGA published its White Paper on Corporate Governance in Japan in which it brought together opinions from various institutional investors, analysts and other professionals operating in Japan and overseas.
While stating that "sound corporate governance is essential to the creation of a more internationally competitive corporate sector in Japan and to the longer-term growth of the Japanese economy and its capital markets," the ACGA declared that all publicly-traded Japanese companies ought to be required to: (i) appoint properly-qualified outside directors through a transparent and rational process, and (ii) disclose in corporate governance reports the manner in which the independence of those directors has been established. The TSE Proposal is a step in that direction, but certain of the ACGA's requests go further.
A greater number of independent directors on the board, and their involvement in the selection and appointment of new directors, would, according to the ACGA: (i) enhance management's access to unbiased judgment on strategic decisions; (ii) add to management additional outside skills and experience not otherwise available (especially in small- and medium-sized companies); (iii) increase adherence to and compliance with best (legal and other) practices through the independent monitoring of executive directors; and (iv) promote positive changes in the company and ensure evolution of corporate governance, increasing the competitiveness of Japanese companies.
In addition, what sets the ACGA apart from some of the more moderate groups is that it has asserted that Japanese public companies should have a minimum of three independent directors. In the medium term, the ACGA suggests that independent directors should comprise at least one-third of the board, and over the longer term, they should be one-half.
Echoing the ACGA, the American Chamber of Commerce in Japan, in its Presentation to the Corporate Governance Study Group on February 13 2009, reiterated the need for rules applicable to all listed Japanese companies and asserted that at least one-third of a company's directors ought to be independent to help ensure the implementation of "global best practices," and stated that all listed companies should provide investors with reports on the backgrounds of outside director and statutory auditor candidates, and any other information that might affect the judgment of such persons or create conflicts of interest.
Japan Business Federation
On the opposite side of the spectrum, there is the Japan Business Federation (Keidanren), which rejected the notion that outside directors must become more independent in its policy proposal Towards Better Corporate Governance (Interim Discussion Paper on Key Issues), published on April 14 2009. The Keidanren insisted that while a corporate governance structure should permit sufficient monitoring of the board's activities to prevent inappropriate practices and enhance both competitiveness and profitability, different forms of corporate governance can achieve the same result, and an arrangement that makes sense for one company may not be suitable for another. The Keidanren asserted that the best method of corporate governance will always be one that has been tailored, after taking into consideration a company's vision, corporate culture, history, strategies and industry.
It suggested that so long as public companies are required to disclose the nature of their corporate governance structure and the rationale that motivated it, shareholders should be able to evaluate the independence in a company's corporate governance, which in turn would assist them in exercising their votes when electing directors and statutory auditors.
The Keidanren also argued that automatically excluding a person from an outside director position due to his previous experience as an employee or officer of a parent company or major business partner or main bank, would entail the exclusion of persons with strong incentives to enhance the company's corporate value (and therefore shareholder value), and those with knowledge and experience relating to the inner workings of the company. Furthermore, truly independent directors could interfere with the natural operation of the company and might fail to adequately influence management.
In Japan, many of the persons who fill outside director and statutory auditor positions do so either after leaving a position they had held at the parent company, major business partner or a main bank, or else hold both positions. The Keidanren believes that this has provided sufficient management monitoring, and no additional independence is needed or should be required.
Finally, the Keidanren argued that a one-size-fits-all rule may cause more harm than good. Instead, requiring greater collaboration and cooperation between the board and the statutory auditors, while expanding the support within the company that is given to and available to the statutory auditors, might strengthen the supervisory function of the statutory auditors and create more change than if the focus is exclusively on independence.
Although there are executives working at TSE-listed companies that support the view that public companies should be required to have directors that satisfy globally-accepted independence requirements, and there are listed companies that have already voluntarily elected outside directors that meet rigid independence criteria, or else voluntarily established nomination or remuneration committees, the vast majority of executives seem to agree with the Keidanren.
The Ministry of Economy, Trade and Industry
In The Corporate Governance Study Group Report published by the Ministry of Economy, Trade and Industry of Japan (METI) on June 17 2009, the METI acknowledged that stock markets today are borderless, with the ratio of foreign holders of Japanese stocks on the rise, and so there is a growing need for Japanese corporate governance to be "more understandable and more convincing to investors around the world". It explained that minority shareholders, including institutional investors, have a "strong expectation" that outside directors and statutory auditors will perform monitoring functions on behalf of the shareholders as they seek to enhance the company's value.
However, reflecting the concerns of the Keidanren about an inflexible standard of independence, the METI perceives a need for balance between "objectivity and distance from management" for outside directors and statutory auditors on the one hand, and allowing persons to serve as directors and statutory auditors when they have incentive to effectively monitor the company and are capable of contributing to the its value with their first-hand knowledge. The METI admits that it is difficult to obtain public shareholder support and understanding if outside directors and statutory auditors have interests that are too closely tied to the decisions of the company. However, in stressing the need for substance over form, the METI asserted that rigid independence requirements might not yield a better system of corporate governance in all cases. Rather, "the governance structure that is most appropriate for each company should ultimately be determined by every individual company, in a consensus-building process that ought to include dialogue with minority investors in the company." The METI called for tolerance of a diversity of company views, saying that listed companies should be free to choose whether or not to appoint truly independent persons, but either way, companies should be compelled to disclose the rationale for their corporate governance, complete with an explanation of the role and function of the directors and statutory auditors.
The Financial Services Agency
Taking a position somewhere between the ACGA and the Keidanren, and serving as the basis for the TSE Proposal itself, Japan's Financial Services Agency (FSA), on June 17 2009, released a Report by the Financial System Council's Study Group on the Internationalisation of Japanese Financial and Capital Markets: Toward Stronger Corporate Governance of Publicly Listed Companies. In the Report, the FSA noted that where statutory auditors have been appointed to supervise the actions of directors serving at large and listed companies there must be at least three statutory auditors (at least half of whom must be outside statutory auditors).
Despite the presence of such statutory auditors, many investors have complained that their monitoring only extends to the legality of the actions, and that they can in practice be ignored because, whether outside or not, they do not have the authority to monitor the propriety of the actions of directors, or to exercise a vote during the selection of director candidates or on any other matters that are subject to board approval. Statutory auditors cannot influence the election of directors. Moreover, investors have also argued that statutory auditors have insufficient resources to conduct their audits, and in many cases, the reliability of the audit function is compromised.
In response, the FSA issued a set of proposals aimed at addressing investor complaints about deficiencies in corporate governance. The central recommendation was for all Japanese companies that are listed on a national exchange to have at least one independent director or independent statutory auditor. The FSA suggested that such a measure was needed to ensure accountability, helping to reduce or prevent reckless decisions by board members and giving them access to unbiased, external opinions. To strengthen the audit process, the FSA also proposed that additional resources ought to be provided, or else that the internal audit and control divisions within a company (which are responsible only to directors, and can therefore be influenced by the board) should cooperate and work closely with the statutory auditors.
According to the FSA, statutory auditors ought to be persons with an in-depth knowledge of finance and accounting, and should be highly independent – although precisely what such independence might entail was left flexible for different companies. At the same time, the FSA maintained that a reporting requirement should be instituted so that shareholders can accurately grasp independence standards in a given company. In the Report, the FSA indicated that it might be feasible (and acceptable to investors) to have one or more truly independent directors, and have the independent directors work closely with the statutory auditors or the director in charge of internal audits to strengthen monitoring.
Will anyone be satisfied?
The TSE Proposal will make few, if anyone, completely satisfied. On the one hand, the requirement for a company to have at least one independent outside director or statutory auditor is a rule that will be applied inflexibly, without regard to the individual history, character and other qualities of a given company. There will be those who will say that a fluid market for such independent persons does not yet exist, and that there will be a shortage. The practical effect of the TSE Proposal, they may say, will be the appointment of persons who lack institution-specific knowledge and expertise, to the company's detriment, rather than to its benefit, which will ultimately harm shareholders.
On the other side of the debate, although having one independent supervisor is better than none, the TSE Proposal does not require companies to have three or more independent directors, which is what investor groups like the ACGA, ACCJ and others have been promoting. Moreover, upon closer examination of the new measures, the freedom given to listed companies to choose the appointment of either an independent director or an independent statutory auditor, or to choose a person that does not satisfy globally-accepted independence requirements, may be a serious corporate governance flaw in the view of foreign investors. Many companies given this option may choose to have only an independent statutory auditor (and not any independent directors). Without at least one independent director, the voice of the statutory auditors, whether independent or not, may get lost. Instead, some investors will likely argue that what is needed is at least one independent director that can deliver directly to the board the opinions of the statutory auditors – not only as to the legality of management's actions, but also as to the propriety of such actions – and exercise his vote against the company's management if it becomes necessary.
Of course, depending on the quality, charisma, experience and overall persuasiveness of that independent director (or lack thereof), it might be that more than one independent voice is needed for the other directors to genuinely hear the message from the independent director-side. One independent director may not be sufficient to protect shareholders. But the approach suggested in the FSA's Report, which, notably, is not being made mandatory in the TSE Proposal, involving at least one independent director working closely with the company's statutory auditors, with sufficient human resources and other forms of support, would be an effective step forward in Japanese corporate governance in the eyes of investors.
*** Authors' note: following the submission of this article for publication, on December 22 2009, the TSE published new rules, including rules that relate to independent directors. Due to the timing of the submission of the final draft of this article, it does not reflect those new rules.
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About the author
Asa Shinkawa has been a partner in the M&A/Corporate Group at Nishimura & Asahi since 2000. She focuses on mergers and acquisitions, tender offers, cross-border and domestic acquisitions and divestitures and going private transactions, restructurings and spin-offs, joint ventures and numerous other kinds of M&A and commercial arrangements across various industries. She has also advised extensively on the application of antitrust law in relation to M&A transactions, joint ventures, co-operative arrangements between competitors, sole-distributorship arrangements, distribution agreements, dealer agreements and other types of commercial arrangements.
She is a graduate of Tokyo University (LLB 1989) and Harvard Law School (LLM 1997). She is admitted to practice law in Japan (1991) and New York (1998). Shinkawa is a frequent contributor to both Japanese and English language publications, and speaks Japanese and English. |
Contact information
Asa Shinkawa
Nishimura & Asahi
Ark Mori Building (Main Reception: 28th Floor)
1-12-32 Akasaka, Minato-ku
Tokyo 107-6029, JAPAN
Tel: 81 3 5562 8500
Fax: 81 3 5561 9711/12/13/14
Email: a_shinkawa@jurists.co.jp
Web: www.jurists.co.jp |
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About the author
James Emerson is a senior foreign attorney and member of the cross-border transactions group at Nishimura & Asahi. His practice focuses on various complex, commercial real estate and project finance transactions, capital markets and international mergers and acquisitions. Prior to joining Nishimura & Asahi in 2009, Emerson was an associate at Skadden Arps Slate Meagher & Flom LLP in New York and at Morrison & Foerster LLP in Tokyo.
Emerson graduated, Phi Beta Kappa and summa cum laude, from the University of Southern California in 1996. He also earned a master’s degree from Cambridge University in 1997 and his JD degree from Harvard Law School in 2003. Emerson is admitted to the United States Court of Appeals for the Third Circuit and is admitted to practice law in New York. He is a native English speaker and is proficient in Japanese, having graduated from two intensive Japanese language courses at Stanford University’s Inter-University Center in 2008 and 2009. |
Contact information
James Emerson
Nishimura & Asahi
Ark Mori Building (Main Reception: 28th Floor)
1-12-32 Akasaka, Minato-ku
Tokyo 107-6029, JAPAN
Tel: 81 3 5562 8500
Fax: 81 3 5561 9711/12/13/14
Email: j_emerson@jurists.co.jp
Web: www.jurists.co.jp |